Monetary Shocks and Stock Returns: Identification Through the Impossible Trinity
49 Pages Posted: 22 Sep 2013
Date Written: September 1, 2013
We present evidence of significant bias in event studies that investigate the effect of U.S. monetary policy on U.S. stock prices. To overcome this bias, we propose a new identification method based on the "Impossible Trinity" theory which argues that an economy with a fixed exchange rate and free capital flow cannot have an independent monetary policy. As an application of this method, we study U.S. monetary policy changes as exogenous shocks to the Hong Kong stock market. We find that a 1% (100bp) surprise decrease in the federal funds target rate increases stock prices by about 5%.
Keywords: stock prices, monetary policy, simultaneity, omitted variables, Impossible Trinity
JEL Classification: E4, E44, E5, E52, E58, F3, F33, G1, G12, G15, G18
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